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Divergence warns that the current price trend may lead to the price changing direction. Divergence is a situation in the market when there is contradictory movement between the oscillator for example RSI and the price of an instrument. In only theory — divergence warns the trader not to believe in the movement of the price as the situation may get reversed i. Understanding the divergence can be more clear if you are using it with the combination of indicators.
One can choose among many available indicators. If the trader or the analyst is able to understand the pattern correctly, they will know the correct time to enter or exit the market, without facing any loss or may make some profits. Here, in the trading market, it indicates the change in the movement of price. Although, the price of a security and the indicator, used by the trader, is supposed to move in the same direction or indicate the same trend.
But when they do not agree with each other, the result is divergence. The divergence can be both negative and positive. The positive divergence signals that there may be a positive upward movement in the price. It is indicated when the technical indicator is moving higher but the price is moving lower. This type of signal is known as a bullish signal or bullish divergence.
The negative divergence signals that there may be a negative or downward trend or movement in the price. It is indicated when the technical indicator is showing a lower movement but the price is showing a higher movement. This type of signal is known as a bearish signal or bearish divergence. These divergences lay between the high points and the low points showed by the price and indicators. Depending upon the position of the price and the indicator, divergences can be classified into four types:.
Regular Bullish Divergence is just a usual signal of an upcoming bullish trend in the market price of an instrument. This divergence is indicated when the price shows the lower low but the indicator shows a higher low. Regular bullish divergence indicates that the ongoing bearish or downward trend is going to end and will be replaced by an upward trend. At this point, traders may go long expecting a favorable return to their investment.
Regular divergences are perfect indicators of a possible reversal in the trend. Hidden Bullish Divergence also shows a possible upward trend but with a signal that the trend will continue. It means that if it is an upward trend, it will continue to go upward.
It is indicated when the price shows a higher low but the indicator is showing a lower low. This marks the end of a downward trend and indicates a start and continuation of an upward or bullish trend. Regular Bearish Divergence. This is indicated when the price of an asset shows a higher high while the indicator shows a lower high. This divergence occurs in the uptrend that signals the traders to find a way out of the market before the downtrend approaches.
When the downward trend approaches with a signal of continuation, it is known as Hidden Bearish Signal. It indicates that the price will start to fall and will continue to fall for a while. This divergence approaches when the price shows a lower high while the indicator shows a higher high.
Divergences are one of my favorite trading concepts because they offer very reliable high-quality trading signals when combined with other trading tools and concepts. Although indicators are somewhat lagging — just like price action is lagging too — when it comes to divergences, this lagging feature is actually going to help us find better and more reliable trade entries as we will see below.
Divergences can not only be used by reversal traders but also trend-following traders can use divergences to time their exits. I do not recommend trading divergences by themselves but they are a good starting point. A divergence forms on your chart when price makes a higher high, but the indicator you are using makes a lower high.
Bearish and bullish divergence. Price and indicator are out of sync. Divergence foreshadows reversal. The RSI compares the average gain and the average loss over a certain period. So for example, if your RSI is set to 14, it compares the bullish candles and the bearish candles over the past 14 candles.
When the RSI value is low, it means that there were more and stronger bearish candles than bullish candles over the past 14 candles; and when the RSI is high it means that there were more and larger bullish candles over the past 14 candles. Understanding when your indicator is high or low is important when it comes to interpreting divergences and I generally encourage traders to look beyond the squiggly lines of their indicators to explore what it really does.
During trends, you can use the RSI the compare the individual trend waves and so get a feeling for the strength of the trend. Here are the three scenarios and the screenshot below shows every single one:. This means that there were more and larger bullish candles in the most recent trend wave than there were compared to the previous wave. When the RSI makes an equal high, it does not qualify as a divergence because it just means that the strength of the uptrend is still up and stable.
Higher highs on the RSI do not show a reversal or weakness. It just means that the trend is progressing unchanged. This is what we call a divergence and in the screenshot below, the divergence signaled the end of the uptrend and it makes a downtrend possible. Classic technical analysis tells us that a trend exists when price makes a higher high — but like too often, conventional wisdom is seldom right and usually simplifies things too much.
A trader who only relies on highs and lows for his price analysis often misses important clues and does not fully understand market dynamics. Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near. A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence.
Keep in mind that a divergence just signals a loss of momentum, but does not necessarily signal a complete trend shift. A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences. Just like any trading strategy, you need to add more confluence factors to make your strategy strong.
Below we see how price made 2 divergences but price never sold off. The divergences, thus, just highlighted short-term consolidation. Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades. However, the first one completely failed and the second one resulted in a massive winner.
What was the difference? Such an approach will impact your performance in a big way. Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price.
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